Introduction
Margin call is a term that you may have come across if you are involved in trading stocks, futures, or other financial instruments. It is a situation where a broker asks a trader to deposit more money into their account to cover the losses incurred on a trade. In this article, we will explain what margin call means and how it works.
What is Margin?
Margin refers to the amount of money that a trader borrows from a broker to buy or sell a financial instrument. It is a form of leverage that allows traders to control a larger position with a smaller amount of capital. For example, if a trader wants to buy 100 shares of a stock that is trading at $50 per share, the total cost would be $5,000. If the trader has a margin account with a 50% margin requirement, they would only need to deposit $2,500 to buy the shares.
Margin Call Explained
A margin call occurs when the value of the trader’s positions drops below a certain level, known as the maintenance margin. The maintenance margin is typically set at 25% or 30% of the total value of the positions. If the value of the positions falls below this level, the broker will request that the trader deposit more money into their account to meet the margin requirement.
Example
Let’s say that a trader has a margin account with a balance of $10,000 and they buy 200 shares of a stock at $50 per share, using $5,000 of margin. The total value of the position is $10,000 ($50 per share x 200 shares). If the maintenance margin is set at 25%, the trader would need to maintain a minimum equity of $2,500 ($10,000 x 25%). If the value of the position drops to $8,000, the equity would be $3,000 ($8,000 – $5,000). This is above the maintenance margin, so the trader would not receive a margin call. However, if the value of the position drops to $7,000, the equity would be $2,000 ($7,000 – $5,000), which is below the maintenance margin. The broker would then issue a margin call, asking the trader to deposit more money into their account to bring the equity back above the maintenance margin.
Consequences of Margin Call
If a trader fails to deposit more money into their account to meet the margin call, the broker may close out some or all of their positions to reduce the risk of further losses. This is known as a margin liquidation or a forced sale. The broker will typically sell the positions at the prevailing market price, which may be lower than the trader’s entry price. This can result in substantial losses for the trader.
Managing Margin Risk
To avoid margin calls and margin liquidations, traders need to manage their margin risk effectively. This means keeping a close eye on the value of their positions and the maintenance margin, and ensuring that they have enough equity in their account to cover potential losses. Traders can also use stop-loss orders to limit their losses on individual trades.
Conclusion
Margin call is an important concept to understand if you are involved in trading financial instruments. It is a situation where a broker requests that a trader deposit more money into their account to cover potential losses. Traders need to manage their margin risk effectively to avoid margin calls and margin liquidations, which can result in substantial losses.
